New government ways of boosting the economy must be found if the current Bank of England stimulus proves incapable of combating the headwinds facing Britain, the head of the City's financial watchdog says.

Rekindling the debate about whether record low interest rates, quantitative easing and lending incentives will work, Lord Turner said further steps may be needed to avoid the risk of deflation.

Turner, one of the candidates to be the next Bank governor, said in a speech in South Africa that the failure to regulate the financial sector stringently enough had created a climate of excessive risk-taking.

Banks were now scaling back, Turner said, starving the economy of credit, adding that "in the face of deleveraging we may need to consider innovative and unconventional combinations of policies to offset deflationary risks".

Sir Mervyn King, the Bank's governor, last week strongly opposed one unconventional policy – money creation by Threadneedle Street to finance the government's budget deficit. King said so-called "helicopter drops" of money could make the Bank insolvent as well as posing an inflationary threat.

The FSA chairman did not specify what he thought was needed if a 0.5% bank rate, £375bn worth of QE and the Funding for Lending scheme failed to work.

"This is an innovative combination of policies, and one which lies far outside past orthodoxy. And if these measures prove insufficient we may have to consider further policy innovations, and further integration of different aspects of policy, to overcome the powerful economic headwinds created by deleveraging across the developed world economies."

Turner said a lesson from the crisis was that commercial banks and the shadow banking system which can create credit and money to finance asset price booms were "inherently dangerous institutions". He added that "optimal regulation of banks and shadow banking must reflect a recognition that the private financial system, left to itself, will tend to create excessive debt contracts, and excessive leverage".

Turner said: "The financial crisis of 2007-08 revealed how deeply flawed were the assumptions of the pre-crisis conventional wisdom. Free market finance left to itself will create huge instability – too much leverage in the real economy and within the financial system, too volatile a new credit supply, too much complexity and dangerous interconnectedness. Increased financial intensity is not limitlessly beneficial."

The Bank of England has been given new powers to ensure financial stability by the government, and Turner said powerful macroeconomic prudential levers, such as countercyclical capital requirements, were essential to prevent a repeat of the 2008 crash. These needed to apply not just at the bank level but in respect to specific sectors – such as commercial or residential real estate – where the danger of self-reinforcing credit and asset price cycles was greatest.

Turner said that conventional monetary policy – cutting interest rates – became less effective in tackling deflationary pressures when the cost of borrowing was close to zero and when banks were damaged by their battering from the financial crisis. "In addition the freedom to use fiscal stimulus is limited by the need to get rising public debt burdens under control.

"Clearly therefore, the policy response has to include unconventional monetary policy – quantitative easing – which as best we can tell has produced a path of real output growth and inflation slightly higher than would otherwise have occurred."

But Turner said quantitative easing alone "may be subject to declining marginal impact", where allowing the private sector to exchange government bonds for money had little impact on demand in the economy.